Protect Yourself

When you think of investments and brokerage firms, you probably think of opening an account and buying stocks, bonds, or mutual funds. When you enter into a subordination agreement, you are making an investment, but the investment is in the brokerage firm itself. This investment can be very risky and is not suitable for everyone. You should never enter into a subordination agreement unless you can afford to lose your entire investment.

We are issuing this Alert because of our concern that an increasing number of investors may be entering into financing arrangements with brokerage firms without fully appreciating the risks or implications of such arrangements. For the same reasons, we also adopted a rule requiring brokerage firms to obtain a signed Subordination Agreement Investor Disclosure Document from an investor before entering into such a subordination agreement with an investor.

This Alert will explain what subordination agreements are, the risks involved with them, and how you can find out what you need to know to make a smarter investment decision.

What is a Subordination Agreement?

A subordination agreement is a contract between you and a brokerage firm where you lend either money or securities or both to the firm. There are two types of subordination agreements.

Subordinated Loan Agreement (SLA). An SLA is used when you lend cash to a firm. The SLA discloses the terms of the loan, including the amount of the loan, the interest rate, and the date the loan will be repaid.

Secured Demand Note Agreement (SDN). An SDN is a promissory note in which you agree to give cash to the firm on demand (i.e., without prior notice) during the term of the note. You also must provide cash or securities as collateral for the SDN. If you use securities as collateral, these securities must be deposited with the firm and registered in the firm's name. You cannot sell or otherwise use them unless you substitute securities of equal value for the deposited securities. Securities and Exchange Commission (SEC) rules require that the firm discount the market value of the securities that you provide as collateral. The discount can vary and can be as high as 30% if you use common stock as collateral.

What are the Risks?

Before entering into a subordination agreement, you should understand the following risks:

No Securities Investor Protection Corporation (SIPC) protection. Subordination agreements are not subject to SIPC protection. Thus, if the broker defaults on a subordination agreement, you can lose your entire investment, including any cash, securities, or accounts that you lend or pledge as collateral.

No private insurance protection. Subordination agreements are generally not covered by any private insurance policy held by the firm. Thus, if the brokerage firm fails to pay the loan, you can lose all your investment.

No priority in payment over other lenders. Subordination agreements cause you to be subordinate to other parties if the firm goes out of business. In other words, you would be paid after other parties are paid, assuming the firm has any assets remaining after it satisfies its debts to other parties.

No restrictions on the use of your funds or securities. The firm can use the funds or securities you lend under a subordination agreement almost entirely without restriction. You should not rely on side agreements with a firm that purport to limit the use of the loan proceeds. These agreements are inconsistent with the subordination agreement and may not be enforceable.

The firm can force the sale of securities you pledge as collateral. If the securities pledged as collateral decline in value so that their discounted value is less than the face amount of the SDN, you must deposit additional securities with the firm to keep the SDN at the proper collateral level. If you do not give the firm additional collateral, the firm may sell some or all of your securities. In addition, if the firm makes a demand for cash under an SDN, and you do not provide the firm with cash, the firm may sell some or all of the your securities.

Caution! While FINRA does review subordination agreements, this does not mean that FINRA has passed judgment on the soundness of these investments. Its review does not include an opinion regarding the viability or suitability of the investment for you or the credit worthiness of the brokerage firm.

What Should I Do If I Want to Invest?

Before entering into a subordination agreement, make sure you get the information you need to make a wise investment choice.

Check out the brokerage firm before you invest. You can get information from the following sources:

FINRA. Check with FINRA BrokerCheck to learn whether the firm is licensed, the types of businesses it operates, and whether there are any disciplinary actions against the firm.

The SEC. Obtain a copy of the firm's report on Form X-17A-5. Form X-17A-5 is the audited financial report that every registered broker or dealer must file annually with the SEC. To obtain a copy of a firm's X-17A-5, please contact the SEC's Office of Public Reference as follows:

Finally, as with any investment, don't allow yourself to be pressured into a quick decision. Consider discussing the investment with an accountant, attorney, or investment professional that you know and trust. It is also important to make sure the investment fits with your financial goals, your tolerance for risk, and makes sense given your income and expenses.

Reference Material

Notice to Members 02-04—Asking Members to Adopt "Best Practice" of Requiring Investors to Sign a Disclosure Document as Part of the Subordination Loan Agreement.

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